Proposed Bank Liquidity Rules: A Threat To Muni Bonds?

By Michael Aneiro

New regulations could exclude municipal bonds from a core list of safe assets that can be held by large banks, but will that really hurt the muni market?

The Wall Street Journal ran a story on Friday saying the Federal Reserve, FDIC and the Office of the Comptroller of the Currency are weighing rules regarding what types of investments should qualify as “high quality liquid assets” – the latest efforts to make sure banks have adequate liquid holdings to fund their operations for 30 days should other funding sources dry up – and it looks like munis may not make the cut. Bloomberg has a story today saying munis are in line to be excluded when the final liquidity rules are announced Sept. 3 if the most recent draft rules are upheld.

Munis are generally high-quality assets, but the muni market, which consists of a disparate array of bonds issued by hundreds of state and local governments, isn’t necessarily liquid once you get too far beyond state general obligation bonds. So how much of a hit would this be to the $3.7 trillion muni market if banks suddenly couldn’t count munis toward their safest holdings?

Some muni market experts say the rules won’t really harm muni prices in general. Anthony Valeri, fixed-income strategist at LPL Financial, says bank buying has been an important source of demand in the muni market, but it has has slowed in recent months and remains comparatively small.

“If confirmed, the new liquidity ruling would reduce bank demand and, at the margin, produce a headwind for the municipal bond market,” Valeri writes today. “However, with banks owning roughly 11% of the municipal bond market, we do not view the regulations as a primary driver of the market. Treasury market direction, broader supply changes, and valuations are likely to play more prominent roles in municipal price movements.”

Matt Fabian of Municipal Market Advisors sees downside if there’s ever a crisis, but says the day-to-day risk to the muni market is isn’t so bad.

“[A]lthough some segments of our market (large blocks of well‐rated, well‐known bonds) are liquid by most standards, the municipal market as a whole presents ‘eﬀective liquidity’ (i.e., in past crises, patient holders have ultimately been able to exit at reasonable prices) as opposed to the ‘structural liquidity’ (i.e., a persistent bid side for all securities) found in other asset classes,” Fabian writes this week. “But the related risk is easy to overstate. We expect that, at worst, their exclusion from HQLA will amplify the downside in tax‐exempts during systemic crises but otherwise likely poses only incremental pressure on prices.”